Replacement Property Rules Pertaining to Real Estate and Business Properties

Posted on September 21st, 2023 in Construction & Real Estate, Domestic Tax

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When a taxpayer (including a corporation) disposes of real estate for more than its cost, the capital gain must be reported on the taxpayer’s income tax return. If the taxpayer previously claimed capital cost allowance (CCA) on the building, then that CCA will be recaptured and included in income as well. However, the Income Tax Act permits a taxpayer, in certain conditions, to elect to defer the recognition of recapture of CCA or capital gains where a property was involuntarily disposed of, or a former business property was voluntarily disposed of, and a replacement property is acquired.

Requirements for the replacement property rules to apply

There are a number of requirements in order to take advantage of the replacement property rules. They are as follows:

A replacement property can be acquired before or after the former property, as long as it meets the other conditions.
For involuntary dispositions such as an expropriation, the replacement property must be acquired before the later of:
- the end of the second tax year following the year proceeds become receivable for the former property; and
- 24 months after the end of the year those proceeds become receivable.
For voluntary dispositions of a former business property, the replacement property must be acquired before the later of:
- the end of the first tax year following the year proceeds become receivable for the former property; and
- 12 months after the end of the year those proceeds become receivable.
To qualify as a former business property, the property must be used by the taxpayer or a person related to the taxpayer primarily for the purpose of gaining or producing income from a business. A rental property does not qualify as a former business property unless it was rented in the year of disposition to a related person who used the property principally for gaining or producing business income.
The replacement property must be acquired to replace the former property, have the same or similar use as the former property and, if the former property was used for the purpose of gaining or producing income from a business, the replacement property must be acquired for the purpose of producing income from the same or a similar business.
A taxpayer must make a valid election to use the replacement property rules.

Reporting requirements

A taxpayer is required to report any recaptured CCA or taxable capital gain arising from the disposition of a former property in the year of disposition. However, where a replacement property is acquired in a subsequent tax year and within specified time limits, the taxpayer may request a reassessment of the income tax return for the year of disposition of the former property. This will generate a refund in respect of the income tax paid on income arising on the disposition.

Election to use the replacement property rules

A taxpayer must elect to have the replacement property rules apply. The election should be made as follows:

If the disposition and replacement take place in the same year, the taxpayer’s calculation (in the income tax return for that year) of the recaptured CCA or the capital gain by virtue of subsection 44(1) will be considered to constitute an election.
If the property is not replaced until a subsequent year, the election should take the form of a letter attached to the income tax return for the year the replacement property is acquired. The letter should include a description of the replacement property and the former property, a request for an adjustment to the recapture of capital cost or the taxable capital gain reported, and a calculation of the revised recapture or taxable capital gain.
If the replacement property is acquired prior to the year of disposition of the property, the election should take the form of a letter attached to the income tax return for the year in which the replacement property is acquired. The letter should include descriptions of the replacement property and the property that is to be replaced. If the taxpayer late-files such an election, it will be accepted if it is filed in the income tax return for the year in which the former property is disposed of, provided it is evident that the new property qualifies as a replacement property.

The calculation of the tax deferral can be complicated. The new capital cost of the replacement property is reduced by the capital gain of the former property that was deferred. As a result, when the replacement property is eventually sold in the future, the now lower capital cost is used in determining the capital gain to be realized. The amount eligible for capital cost allowance purposes will also be reduced, as it is affected by both the deferred capital gain and the deferred recapture. We at DJB are here to help you work through this complicated tax filing to give you the best tax filing position.